Get Better S&P 500 Diversification Using These ETFs

Summary

• The S&P 500 index is full stocks from all sectors and industries.
• Popular index ETFs, such as the SPY, may reduce diversification by concentrating heavily on specific stocks and sectors.
• A few alternative ETF choices are discussed and I encourage you to share your methods.

Why do many investors buy the SPDR S&P 500 ETF (NYSEARCA:SPY)?

• Low expense ratio
• Broadly diversified
• Tax efficient
• High Liquidity

This article will focus in on the topic of diversification. Is the SPY an appropriate vehicle for a well diversified fund? Some might assume that this fund would provide one-stop shopping as it contains 500 mid to large-cap stocks in all sectors. An added bonus is that the cap-weighting scheme enables lower turnover which translates into a cheap expense ratio. What more could you ask for?

S&P 500 Cap-Weighting Woes

It is important to remember that the S&P 500 is meant to represent large-cap U.S. equities and was not designed to provide investors with broad and balanced diversification. The cap-weighting scheme which helps this fund keep the expense ratio down will actually work against the quest for broad diversification.

• Although you have 500 stocks, the largest 10 make up over 20% of the portfolios weight.
• The smallest 10 holdings make up 0.15% weighting.
• Sector weighting will be greatly influenced by the largest stocks.

Because the largest 50 stocks make up almost 50% of the fund, one might begin to wonder why you would even want to bother with the smallest 250 stocks which make up less than 15% of the entire funds weight. It sounds far more impressive to say you have 500 stocks in a fund and insinuates far more diversity than what you actually get.

Sector Imbalances

This Seeking Alpha article goes back to 2012 and it has some interesting visual displays on how the sector weighting has changed in the S&P 500 index. Tech weighting has a wide range between 5% - 35%.

Here is the current sector breakdown:

• Technology 25.32%
• Financials 17.47%
• Healthcare 13.28%
• Consumer Cyclicals 12.99%
• Industrials 10.45%
• Consumer Non-Cyclicals 7.86%
• Energy 5.49%
• Utilities 2.71%
• Basic Materials 2.21%
• Telecommunications 1.91%

The top 2 sectors have almost as much weighting as the bottom 7. What we are seeing is that the S&P 500 is heavily tilted towards a concentrated group of stocks based on how expensive the stock is. This, in turn, changes our sector weighting over time. The sector weighting is imbalanced and it is hard to manage because it keeps changing based on what sectors the most expensive stocks are in.

How To Increase Diversification

There are many ways in which you can balance out your portfolio and here are just a few to get you started. We will look at sector, country (not S&P 500 stocks mind you), position and volatility balancing. We will also consider a couple examples which roll some of these features into a Smart Beta package.

Equal Sector Weights

If you wanted to make an equal-sector play with S&P 500 stocks, you could buy all the sector SPDRs in equal amounts.

• Consumer Discretionary (XLY)
• Consumer Staples (XLP)
• Energy (XLE)
• Financials (XLF)
• Health Care (XLV)
• Industrials (XLI)
• Materials (XLB)
• Real Estate (XLRE)
• Technology (XLK)
• Utilities (XLU)

An easier way would be to hold the ALPS Equal Sector Weight ETF (EQL) which does the same thing while extracting a small fee. Remember that diversification does not have the goal of out-performing but instead to spread out risk.

Country Balancing

Perhaps you want to diversify across countries and not sectors. In that instance you might be interested in the Invesco (IVZ) offering of PowerShares MSCI Emerging Markets Equal Country Weight Portfolio (EWEM), although you are diverging from S&P 500 companies in this instance. I still thought this was worth mentioning though.

Equal-Weight Positions

Another valuable way to diversify in the S&P 500 index is by equal-weighting the positions. This will mitigate some of the risk if ever the most expensive and largest-cap stocks should crash. Recall that in the cap-weighted version of the S&P 500, the top 10 stocks made up over 20% of the portfolio weight. An equal-weight portfolio has less stock-specific risk. The PowerShares S&P 500 Equal Weight Portfolio (RSP) would be one option. It is also worth noting that the sectors in RSP are slightly more balanced at this time than the SPY.

Equal Volatility Contribution

Equal-weighting and cap-weighting has another type of concentration risk. Some stocks are more volatile than others and holding a slow moving stock in equal dollar amounts to a highly volatile stock will create an imbalance in how much volatility risk each stock contributes. Cap-weighting also doesn't mitigate this type of risk. If the largest 20 stocks behave erratically, you are assuming a lot more volatility risk than you might have with a different weighting scheme.

If this is a concern of yours you might decide to invest in the VictoryShares US 500 Volatility-Weighted ETF (CFA).

Getting Fancy With Factor Tilts and Smart Beta

Then you have other themed options if you want an S&P 500 fund which weights both individual positions within a sector equally as well as the sectors themselves. Both of the following funds are suitable for income investors seeking higher dividends.

• The ALPS Sector Dividend Dogs ETF (SDOG) is one viable option which seeks high yield in the S&P 500 while balancing out sector and position weights.
• Another similar fund which has the added benefit of including the concept of dividend sustainability combined with high yield is found in the AAM S&P 500 High Dividend Value ETF (SPDV). This well-designed ETF also balances out sector and position weights. Of the two ETFs, I strongly encourage investors to consider SPDV which I feel is a superior design and at a lower expense ratio. It is one of my top ETF picks at the moment.

I encourage you to read about these 2 dividend ETFs in this article.

Summary

So where does all this leave you? If your only objective is to mirror the S&P 500 cap-weighted index then a fund like the SPY will surely meet that objective.

On the other hand, you might want to seriously think about the concentrated sources of risk that are found in such an index. You have a weighting tilt towards the biggest of the big which can lead to imbalances in certain sectors and place too much importance on the outcome of a single company. If your goal is to diversify way some of this risk, you should consider putting together your own portfolio full of well-chosen stocks or perhaps one or more of the ETF suggestions outlined above.

But now over to you...what methods do you use to diversify within the S&P 500 index?

Note: If you would like to read more about various portfolio enhancing techniques as well as my dissection of various ETFs, please click the orange 'follow' button at the top of the page. Many thanks!

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.